The Dangers of Thinking Like an Economist

“Thinking like an economist” is one of those things you’ll see on the pages of every book released during the initial attack wave of pop economics books starting around 2006. In fact, the authors of such books set out with the explicit aim to educate the average person about the basics of economics: demand and supply, comparative advantage, opportunity cost, cost-benefit analysis, externalities, and of course the most beloved mantras: ‘people respond to incentives‘ and ‘there’s no such thing as a free lunch‘.

The typical economist’s mindset is a logical, dispassionate (though not necessarily uncaring) analyst who weighs up situations and policies using basic principles, bearing in mind there are always trade offs and no perfect solutions. Economists usually weigh things up with efficiency in mind, thinking of equitability as an important but often opposed goal to efficiency, and one that should probably be considered separately (this stems from Kaldor-Hicks efficiency, which suggests that pareto optimal policies can be combined with redistribution policies to produce the best possible outcome in terms of both efficiency and equity. Sadly, in practice this means economists sometimes just advocate the former, with the proviso that the latter could happen, but don’t worry as much as they should about whether the redistribution actually does happen).

There are obviously areas where economist’s toolkit applies. Cost-benefit analyses are appropriate for business plans and plans in other organisations. Opportunity cost is relevant when keeping the weekly shop within a budget: if we buy the biscuits, we won’t have enough for the cereal bars, etc. The economic way of thinking also has unexpected applications: for example, economists have done commendable work in the field of organ donation.

However, problems with the ‘economic way of thinking’ arise under certain circumstances. This is commonly when actions have outcomes that are fundamentally unknown, or are incommensurable. What is the opportunity cost of me writing this blog post? Well, I could be writing a different blog post, but I have no idea which one my readers would prefer. That’s assuming I evaluate blogging solely in terms of one metric, like page views, which obviously isn’t true. Alternatively, I could be reading a book; perhaps I’d get an idea for a better post for that, so over the long term reading would be more fruitful. I could also be sleeping, cooking, at the pub, or any number of things, but weighing up the various trade offs and benefits of these actions ‘like an economist’ is simply not possible.

I believe there are ample examples of economists extending their economist’s toolkit beyond where it is appropriate. I will note that good economists realise the limits of their approach, and would probably not endorse the (sometimes absurd) instances of ‘economic imperialism’ I am about to present:

Politicial science. Economists extended their toolkit to political science with public choice theory, which supposes that politicians and voters are rational self-maximisers who act to further their own interests, be they power, prestige, financial gain or what have you. This found its reductio in Bryan Caplan, who suggested that voters are rationally ignorant of politics because the costs outweigh the benefits, and so economists (who are obviously right about everything) should dictate public policy. You know, like in Chile.

Fortunately, this theory is wrong. Research, the best coming from Leif Lewin, has found that politicians and voters act in what they perceive to be the general interest, not narrow self interest. People vote and act out of a sense of obligation and citizenship, not because of any cost benefit analysis they partake in. Public servants are generally public spirited and less motivated by money than those in the private sector. While special interest groups are a problem, economists are better off turning to political scientists if they want to analyse this further, who have known what I outlined above for a long time.

The environment. Some of economist’s basic tools are easily shown to be absurd when applied to environmental analysis. It is not possible to place a monetary value – economist’s go to unit – on most environment variables. How do we compare the ‘value’ of a lake with the economic costs of a carbon tax? Is there some level of carbon tax at which we would forego every lake on earth rather than apply it? How do we compare, say, the depletion of coal with a rise in the sea level? These things have many different metrics by which they can be judged. The financial metrics used by economists are surely among them, but they are only a small part of the picture.

Another problem arises when looking at possible future environmental outcomes, as probabilities are fundamentally unknowable. Some try to approach the issue of global warming and environmental catastrophe by weighing up probabilities and doing cost-benefit analyses. But how do we propose to calculate the probability of environmental disaster? We don’t have a set of earths we can ‘run’ to evaluate how often catastrophe occurs; climate models display chaotic behaviour that is highly dependent on the accuracy of initial conditions. The fact is that we simply don’t know how likely disaster is, what its impacts will be, and framing it in such a way is deeply misleading. Furthermore, even if the probabilities were known, what matters is not just the weighted relative costs and benefits, but the potential for absolute disaster. If there is a 1% chance the world will end unless we do x, we shouldn’t do a cost-benefit analysis. Instead, assuming x is feasible, we should simply do it.

The law. As Yves Smith details in ECONNED (pp. 124-126), Chicago School economists managed to persuade first legal theorists, and then those involved in the legal system itself, of the efficacy of their way of thinking, eventually forming the ‘law and economics’ school. Since this was Chicago, it will not surprise you to learn that this approach largely consisted of a focus on efficiency over, say, due process, promoted deregulation, and rejected notions of corporate social responsibility. Nor should it surprise you that the movement had a large degree of – ahem – ‘support’ from various moneyed interests.

Theoretically, I find the corporate social responsibility position to be incoherent. Empirically, it’s obvious that the framework economists had a substantial part in setting up has failed. Fraud has risen; the changes in anti-trust have not had the benefits that economists predicted; we had a financial crisis in 2008 as a result of the regulatory framework put in place. Note that this isn’t an ideological point: you can think that the regulation was too loose, too tight, or simply wrongly formulated. But in general, defending the exact thinking and framework that led to the crisis is absurd.

Economists take pride in the seeming versatility and simplicity of their framework, and they are eager to apply it to other social sciences. That economists conclusions are, to quote Keynes, “austere and often unpalatable, len[d them] virtue”, especially when contrasted with less mathematically certain social sciences, such as sociology. But oftentimes economists act to displace existing theories without really considering the existing viewpoint. And oftentimes that existing viewpoint has more to it than economists, trained as they are to see things a certain way, might perceive. Hence, economists should always careful when venturing onto new intellectual turf, as otherwise they risk missing vital insights long known to others, insights to which their framework blinds them.

Theory of the Firm, or Theory of the Farm?

It would be silly to suggest that all of neoclassical economics is simply ‘wrong.’ I happen to think much of it is, sure, but some is right, and some may be merely incomplete. However there is another possibility, one I want to focus on in this post: some neoclassical theories are sound only if one defines for them a clear domain. In mathematics, a domain refers to the range of numbers one can feed into a function (what you ‘do’ to the number) and get non-nonsensical (sensical?) answers. Similar rules apply to many scientific theories: the perfect gas model is not appropriate for steam; Newton’s Laws do not apply at very large or very small levels, etc etc.

Economists do already use domains, to a limited extent. This is mostly done in theories of the firm, for which there are different ones depending on the number of firms ranging from perfect competiton to oligopoly through duopoly and finally monopoly. These theories are only supposed to hold in industries with the appropriate number of firms. However, even within these there are few criteria for distinguishing between when a firm will behave, for example, Cournot-y (varying quantity only) and/or Bertrand-y (varying price only), and hence which of these models is appropriate. So economists might still have a hard time knowing when to use which theory. DSGE has similar problems.

One area I’ve been thinking might be more sound if a specific domain – agriculture – were applied to it is marginalist economics: specifically, the much maligned perfectly competitive theory of the firm. It is perhaps no coincidence that economists are rather keen on using examples from agriculture in their parables about marginalist concepts: it’s the area where their analysis is most appropriate. There are a few reasons to believe this:

(1) Agriculture, for the most part, has perfectly divisible inputs and outputs. These are a core assumption of basic producer (and consumer theory), one which is blatantly unrealistic in most cases. However, it may be realistic in agriculture. Food and fertiliser are literally perfectly divisible, as they can always be cut down to smaller quantities; certainly at any level relevant for production. Livestock are not perfectly divisible when alive, but even so they are generally farmed in large quantities that can be continually adjusted, so perfect divisibility is at least a good approximation. Tractors, ploughs etc. are example of indivisibilities, but they are not often purchased and can be thought of as the exception to the rule, covered under ‘fixed capital.’

 
(2) Diminishing marginal returns. Agriculture is one of the few areas where we observe rising costs as output rises. This is partly because a major factor of production – land – is fixed. This is a standard assumption for the short run neoclassical theory of the firm; with land, it is also true in the long run, though some improvements in productivity can be made over the long run with the aforementioned fixed capital expansions.

 
(3) Perfect competition. Nothing better resembles the atomistic neoclassical ideal than many farmers competing on a single market with homogeneous goods like wheat, not having any discernible effect on price. With certain foods, some product differentiation (through quality) might be observed but even this would be captured by the theory of imperfect competition. Overall, a farmer is less likely to have discretion over the price of what they sell than, say, a retail store, or a lawyer.

 
(4) Lack of clustering or ‘QWERTY‘ effects. It is an obvious observation that firms in particular industries tend to cluster together geographically. Manufacturing requires a continuous stream of inputs, so firms at different stages in the supply chain will group together to minimise transaction costs. Manufacturing often – though not always, to be sure – requires workers with a particular set of skills, so employees and employers who best match together will tend to converge. Services, by their nature, requires face-to-face interaction, as well as even more specialised skills, so they too will group together.  In both cases the easy transfer of knowledge around clusters also helps significantly. Clusters become self-enforcing: you set up shop in a cluster because everyone else in your industry is there. QWERTY effects create emergent properties that may suggest a role for government intervention.

However, agriculture, in most cases, does not exhibit QWERTY-like characteristics. First, agriculture requires large expanses of land so it is difficult to create ‘clusters.’ Second, most agricultural labour is not particularly specialised. Third, agriculture also follows an obvious harvesting cycle, so rather than a continuous stream of inputs, there are intermittent large purchases of supplies, making transportation costs less of a systemic issue. Fourth, agriculture does not really rely on information about new trends, management, techniques or what have you; it has followed similar techniques for centuries.

The reader might note that I’ve primarily been referring to extensive agriculture, rather than intensive agriculture – market gardens and so forth. Intensive agriculture does exhibit some characteristics similar to extensive farming: it produces the same type of goods, for a start, so much of the above still applies. Nevertheless, the use of technology and organisation is greater than extensive farming, and market gardens generally take up a smaller area, which suggests that the perfectly competitive market may not be appropriate. Modern market farming might be thought as a way to ‘capitalist-ise’ agriculture, hence rendering the perfectly competitive theory inappropriate.

So what are the implications of this, for extensive farming at least? Seemingly, our conclusions will align with the conclusions of basic economic theory. Price controls and subsidies are not advised under normal circumstances or in the name of long term policy goals; a monopoly would probably not be a result of innovation and would be unlikely to be superseded by technology, and so would be unambiguously bad.

Most of all, economists will be pleased to hear that their favourite theory, comparative advantage, is more directly applicable in the world of agriculture. This is for two main reasons. First, the most commonly used rationale for why a country might have ‘comparative advantage’ – resource endowments – is obviously applicable in agriculture: nobody questions why the UK doesn’t try to create a cocoa industry, or why New Jersey doesn’t grow as much wheat as Iowa. Fertility of soil and climate are determined by powers mostly beyond humanity’s control, and we must specialise according to this. Second, unlike manufacturing, short term losses in trade will not strengthen an industry to the point where it is more efficient in the long term.

This is basically a ‘market knows best’ mantra that may not sit well with my regular readers. To be sure, there will still be exceptions where governments might intervene: environmental concerns; ensuring national self sufficiency; emergencies; basic standards. Nevertheless, the disaster that is the CAP, with absurdities such as food mountains and paying farmers not to use their fields, as well as the effect it has on farmers in poor countries, seems to illustrate that if economist’s favourite creeds hold anywhere, it’s in agriculture.

Model-wise, there will still be issues with perfect competition even in agriculture, where it is at its most relevant. I fully expect superior, more comprehensive theories than the perfectly competitive firm can be (and have been) developed for agriculture. Nevertheless, insofar as perfect competition might apply to anything at all, it seems most suited here. It would at least be a start for economists to admit certain theories have only limited application, instead of extrapolating highly restrictive models onto situations where they don’t apply.

Economists and the ‘As If’ Argument

Many economists will admit that their models are not, and do not resemble, the real world. Nevertheless, when pushed on this obvious problem, they will assert that reality behaves as if their theories are true. I’m not sure where this puts their theories in terms of falsifiability, but there you have it. The problem I want to highlight here is that, in many ways, the conditions in which economic assumptions are fulfilled are not interesting at all and therefore unworthy of study.

To illustrate this, consider Milton Friedman’s famous exposition of the as if argument. He used the analogy of a snooker player who does not know the geometry of the shots they make, but behaves in close approximation to how they would if they did make the appropriate calculations. We could therefore model the snooker player’s game by using such equations, even though this wouldn’t strictly describe the mechanics of the game.

There is an obvious problem with Friedman’s snooker player analogy: the only reason a snooker game is interesting (in the loosest sense of the word, to be sure) is that players play imperfectly. Were snooker players to calculate everything perfectly, there would be no game; the person who went first would pot every ball and win. Hence, the imperfections are what makes the game interesting, and we must examine the actual processes the player uses to make decisions if we want a realistic model of their play. Something similar could be said for social sciences. The only time someone’s – or society’s – behaviour is really interesting is when it is degenerative,  self destructive, irrational. If everyone followed utility functions and maximised their happiness making perfectly fungible trade offs between options on which they had all available information, there would be no economic problem to speak of. The ‘deviations’ are in many ways what makes the study of economics worthwhile.

I am not the first person to recognise the flaw in Friedman’s snooker player analogy. Paul Krugman makes a similar argument in his book Peddling Prosperity. He argues that tiny deviations from rationality – say, a family not bothering to maximise their expenditure after a small tax cut because it’s not worth the time and effort – can lead to massive deviations from an economic theory. The aforementioned example completely invalidates Ricardian Equivalence. Similarly, within standard economic theory, downward wage stickiness opens up a role for monetary and fiscal policy where before there was none.

If such small ‘deviations’ from the ‘ideal’ create such significant effects, what is to be said of other, more significant ‘deviations’? Ones such as how the banking system works; how firms price; behavioural quirks; the fact that marginal products cannot be well-defined; the fact that capital can move across borders, etc etc. These completely undermine the theories upon which economists base their proclamations against the minimum wage, or for NGDP targeting, or for free trade. (Fun homework: match up the policy prescriptions mentioned with the relevant faulty assumptions).

I’ll grant that a lot of contemporary economics involves investigating areas where an assumption – rationality, perfect information, homogeneous agents - is violated. But usually this is only done one at a time, preserving the other assumptions. However, if almost every assumption is always violated, and if each violation has surprisingly large consequences, then practically any theory which retains any of the faulty assumptions will be wildly off track. Consequently, I would suggest that rather than modelling one ‘friction’ at a time, the ‘ideal’ should be dropped completely. Theories could be built from basic empirical observations instead of false assumptions.

I’m actually not entirely happy with this argument, because it implies that the economy would behave ‘well’ if everyone behaved according to economist’s ideals. All too often this can mean economists end up disparaging real people for not conforming to their theories, as Giles Saint-Paul did in his defence of economics post-crisis. The fact is that even if the world did behave according to the (impossible) neoclassical ‘ideal’, there would still be problems, such as business cycles, due to emergent properties of individually optimal behaviour. In any case, economists should be wary of the as if argument even without accepting my crazy heterodox position.

The fact is that reality doesn’t behave ‘as if’ it is economic theory. Reality behaves how reality behaves, and science is supposed to be geared toward modelling this as closely as possible. Insofar as we might rest on a counterfactual, it is only intended when we don’t know how the system actually works. Once we do know how the system works – and in economics, we do, as I outlined above – economists who resist altering their long-outdated heuristics risk avoiding important questions about the economy.

Falsification in Economics

It doesn’t make any difference how beautiful the hypothesis (conclusion) is, how smart the author is, or what the author’s name is, if it disagrees with data or observations, it is wrong.

- Richard Feynmann

Our empirical criterion for a series of theories is that it should produce new facts. The idea of growth and the concept of empirical character are soldered into one.

- Imre Lakatos

A remarkable characteristic of economics is the sheer staying power of theories, even with a lack of empirical evidence to corroborate the propositions of these theories. In my experience, it is not uncommon for lecturers to remark that the lack of evidence for a theory has been a ‘problem’ for economists (though apparently not enough of a problem for them to throw out said theory). Often textbooks, lectures and discussions of theory make no reference to evidence whatsoever, and where they do it is trivial (for example, representative agent intertemporal macroeconomic theory predicts that governments will run periods of deficits followed by periods of surplus).

In the paragraphs that follow, I’ll examine a few cases of where I believe economics has gone off the mark in this respect. Specifically, I evaluate Marginal Productivity Theory, Walrasian Equilibrium, and The Solow Growth Model. I avoid theories such Real Business Cycle models and the Efficient Markets Hypothesis, partly because they have been done to death, but more importantly to demonstrate that the bad theories in economics are not merely the result of a few ‘wild cards’ at Chicago. On the contrary, I believe an anti-empirical approach is institutionalised within mainstream economics and that economics must undergo a paradigmatic shift to move away from these theories.

Marginal Productivity Theory (MPT)

The common interpretation of MPT is that it predicts workers will be paid ‘what they’re worth.’ In fact, this is not correct; the theory predicts that average productivity of workers will be positively related to wages, rather than each worker getting precisely their ‘just desserts.’ In any case, the result is that MPT predicts that compensation will increase as productivity increases. Hence, graphs such as this one – which you have likely seen before – pose a problem for MPT:

I have seen several responses to the problems presented by graphs like this. The first is that non-wage benefits have risen, which isn’t shown in this data. The second is that the adjustments for relative prices have been incorrectly applied, and consumers have more purchasing power than it first seems. However, estimates exist which take all of these things into account, and they still come to the same conclusions: most people’s overall real compensation is not increasing, even though their productivity is.

Another response would be that marginal productivity did well until the 70s, so maybe it remains useful. This is special pleading. A theory must be equipped to explain all phenomenon within its domain (in this case the labour market), rather than selectively applied where it suits the economist. If the laws of physics suddenly stopped working, can you imagine physicists making this defence? Saying ‘MPT will work except when it doesn’t and if it doesn’t we will throw our hands up in the air and carry on’ is not science. The fact is that such a sudden and clear decoupling of wages and productivity poses a clear problem for advocates of MPT, one which requires either a thorough explanation or discarding the theory altogether.

Walrasian Equilibrium

Walrasian equilibrium is one of the more absurd pieces of theory in economics (which is saying something). There are two (rational) agents with endowments of two factors of production, which they hire out to two profit-maximising producers. The producers use these factors of production to create two consumer goods, then the consumers purchase them. Everyone behaves as if they are perfectly competitive (they can’t influence prices) and everything happens simultaneously. There is no direct trade; instead individuals trade through the market (which comes from god outside the model).

The behaviour of consumers in this model is tautological. They consume based on a predetermined utility function that cannot be observed. Hence, they consume what they were always going to consume based on the chosen, non-empirical parameters of the model. This doesn’t tell us anything.

The behaviour of producers in this model is observable in the real world and hence not tautological. It is also not what happens in the real world. Some firms maximise profits, but most don’t; those firms that do maximise profits equate MC and MR is clearly false.

The only prediction this model as a whole makes is that the initial distribution of endowments will affect what is produced, how it is distributed, how much is produced and the price of what is produced. In other words: the initial resource distribution of a market economy affects its subsequent workings. This is trivial, and easily shown by theories that are based on more realistic assumptions (such as Sraffa).

The Solow Growth Model

The Solow model, to me, seems to be a textbook case of ‘bad science.’ This is clear from the story of its development (a story anyone who has taken development or macroeconomics will know).*

The Solow model predicts that, due to diminishing returns to capital, developing countries will catch up with developed countries in terms of GDP. At a low level of capital stock, the potential returns to investment are high (e.g. irrigating/ploughing a previously unkempt field). As the stock of capital increases, the returns to investment decrease and the growth rate of a country balances out. Hence, all countries will converge to a similar long term growth rate.

That this prediction is false is no longer debated. In the 1980s, William Baumol provided evidence that seemed to support the hypothesis. This was quickly disputed by Brad Delong, who noted that Baumol had used a sampling bias – he only included countries which were developed, effectively assuming his conclusion. Delong included more countries and found no evidence of convergence.

However, economists weren’t ready to give up. The prediction of the Solow model was reframed as conditional convergence: that is, provided countries have the right institutions, social cohesion, etc. they will converge in terms of growth. This, to me, seems trivial. The entire point of development economics is that the conditions in poor countries are not conducive for them to develop and so catch up with the developed countries. The Solow model doesn’t ask how a country might achieve this, but only says that it is a necessary condition for development, something development economists have always known. Hence, the Solow model is irrelevant for the immediate problem of development economics, which is how exactly we can help poverty-stricken countries get off the ground.

Is Economics That Bad?

In the interests of balance, it is worth noting some predictions made in economics that have been either empirically verified or dropped subsequent to falsification. Quantity of money targeting was tried, and failed, in a few countries, which led to Milton Friedman himself repudiating it (though economists still erroneously use the same framework which led to it). The lifetime consumption hypothesis (and non-utility based consumer theory in general) display good empirical corroboration and have all the hallmarks of a ‘good‘ scientific approach. The Phillips Curve as used by economists was modified in light of evidence in the 1970s. Both the multiplier and the Giffen Good are good examples of non-trivial, clear, falsifiable predictions, though I will not comment on evidence for them because that would take a post for each one.

Nevertheless, the record as a whole is not good. Theories from over a century ago look, and are taught, the same way as they were when they were initially adopted. New ideas that are not even disputed by economists, such as behavioural economics, are slow to be adopted, and when they are adopted are presented as a ‘special case’ and in a way amenable to the core framework, which is, of course, still taught alongside them. As far as I’m aware, there is no clear cut case of a neoclassical theory being completely thrown out and never mentioned again. This alone should be an indicator that the scientific method is not at work in economics.

*I am ignoring the internal problems with models of this ilk, and the fact that Solow himself seemed to agree with many of these criticisms.

A Unifying Principle for Economics?

Commenter Dan thinks economics has not yet found its watershed moment:

Think about Biology before DNA was discovered or Geology before plate tectonics was understood, both disciplines had learned a lot but they still lacked a comprehensive model that made everything fit into place.

I am sympathetic with this viewpoint. Heterodox criticisms come at economists thick and fast – personally, I think most of these criticisms are valid and very little of neoclassical economics should be left. Yet neoclassical economics persists.

However, in my opinion this isn’t because economics lacks a unifying theory; it’s the exact opposite. Economists already think they have found a unifying concept: namely, the optimising agent. Consumers maximise utility; producers maximise profits; politicians maximise their own interests/their ability to get reelected. Sure, there are a few constraints on this behaviour, but overall it is the best starting point. It all blends together into a coherent theory that can tell a plausible story about the economy. I find economists are resistant to any theory that doesn’t follow this methodology.

I have gone over my problems with this approach many times, so I shan’t repeat myself. The important question is what an alternative theory would look like.

The typical definition of economics is the study of how resources are allocated. Hence, a unifying theory should empirically and logically do a satisfactory job of explaining prices, production and distribution. Such a theory would be able to underlie virtually any economic model in some form, whether being the wider context of a microeconomic phenomenon, or the basis of macroeconomic phenomenon. No easy task, then, but luckily many approaches of this nature already exist.

Alternative Theories of Behaviour

If we want to stick with agent-based explanations of the economy, there are any number of alternatives to the ‘optimising’ agent. Among these are:

• Maslow’s hierarchy of needs.
• ‘Satisficing‘ agents.
• Class-based theories.

I consider all of these approaches useful, but none of them sufficient for the task at hand.

In the case of the first two, replacing ‘optimising’ agents with ‘satisficing’ agents isn’t exactly revolutionary. Maslow’s hierarchy can, in fact, work as a utility function. In both cases, we still run into similar problems of aggregation and of reductionism. And we end up trying to shoehorn every decision into a particular approach. The simple truth is that agents have a lot of different motivations for their actions and sometimes these aren’t always clear, even to them.

My main issue with these, and any agent based approach, is that they aren’t necessarily relevant for the wider question of resource allocation in society. Individualist-based neoclassical economics has to reduce things down to a  few agents with only a few goods in order to have any conclusions whatsoever; I can’t help but feel similar problems would emerge here. Class struggle may determine distribution but it doesn’t tell us much about what is produced and at what price it is sold. In order to understand how production takes place and prices are determined, we will have to look elsewhere.

A Theory of Value

The value approach has a lot of pluses. A theory of value underpins the explanation of relative prices, and also has normative implications that recognize the inevitable value judgments in economics. The only problem I have here is that I’ve yet to find a convincing theory of value – the two most widely known are the neoclassical/Austrian subjective theory of value and the Labour Theory of Value (LTV).

I object to the idea that prices merely reflect subjective valuations for the basic reason of circularity: prices must be calculated before subjective valuation takes place, so they cannot purely reflect subjective values.

I have more sympathy with the LTV (mostly because its proponents seem to have coherent responses to every criticism thrown at it), but I remain unconvinced. The defences of the labour theory of value tend to rest on appeals to ‘the long run’ and ‘averages” of socially necessary labour time. These may be useful, but, like the neoclassical ‘long run’ approach they seem to leave open the immediate question of what’s going on in the economy and what we can do about it.

In my opinion, these approaches both contain some validity, and are not mutually exclusive. I tend to agree with Richard Wolff, who asserts that suggesting one has refuted the other is like saying knives & forks have refuted chopsticks. Both are useful; neither are all-encompassing theories. I also believe both are compatible, to some degree, with my favoured approach:

The ‘Reproduction and Surplus’ Theory

This approach is the one emphasised by Sraffians and Classical Economists. It starts from the basic observation that society must reproduce itself to survive, and that generally society manages this, plus a surplus. The reproductive approach emphasises what I believe to be an important aspect of capitalism, and perhaps all systems: the collective nature of production. Industries are interdependent; people work in teams; various institutions, often state-backed or provided, underlie all of this. Hence, no special moral status is accorded to prices or the allocation of surplus, except that prices must be appropriate for the continued existence of industries and society as a whole.

On first inspection the ‘insight’ that society must reproduce itself might be considered trivial, but following through its implications can yield interesting and useful conclusions. The framework can be used to determine prices technically, independently of either preferences or values. It emphasises the interdependent nature of the economy: if one industry or input fails, it has severe knock on effects. For this reason, it would do a great job of explaining both the oil shocks and resultant stagflation of the 1970s and the 2008 financial crisis, something modern macroeconomics cannot manage.

On top of this, the model is versatile: it can interact with its institutional environment, which determines key variables exogenously (e.g. the monetary system determines interest rates, political power determines distribution). The classical approach is, for example, compatible with class theories of income distribution, post-Keynesian theories of endogenous money and mark-up pricing, and even neoclassical utility maximising individuals! Probably the most promising and complete framework out of them all – I look forward to further developments of this approach.

It is feasible that the task of finding a watershed moment is not possible in the fuzzy world of social sciences. Psychology and sociology are both characterised by competing approaches; psychology in particular has improved since the neoclassicals Freudians were dethroned. If neoclassical economics has taught us nothing else, it’s the importance of not being trapped by particular theories for want of elegance, which is why there is a lot to commend in the institutional school of economics.

Nevertheless, I think there is scope for exploring unifying principles. Progress in neurology may provide such a foundation for psychology; similarly, ideas such as societal reproduction could equally be applied to sociological concepts such as the role of beliefs, class, sports or what have you. As far as economics goes, such a substantial step forward could be what’s required to displace neoclassical economics, whose staying power, in my opinion, cannot be accorded to either its empirical relevance or its internal consistency. Perhaps neoclassical economics persists simply because its building blocks are so well defined that other approaches seem too incomplete to offer their opponents sure footing.

What on Earth is Utility, Anyway?

In mainstream economic models, consumer’s behaviour is generally assumed to follow a ‘utility function.‘ Consumers derive utility (creatively measured in ‘utils’) from whatever they consume, and they will attempt to maximise this subject to their budget constraint – and, perhaps, at a later level, some extra terms to incorporate behavioural quirks, social pressure or what have you. Unfortunately, even with modifications, the concept of utility is an explanation of behaviour that is questionable at best.

The first conundrum – as posed in the title of this post - is exactly what form utility takes. Is it supposed to be some sort of cumulative attribute that people collect as they go through life, like a stat on a video game? Or is it a temporary sensation experienced after consumption, so that economic agents are effectively utility junkies, chasing around temporary highs? There may be a case for regarding anyone who truly maximised utility as clinically insane and in need of help. In any case, thoughtlessly following predetermined utility functions leaves neoclassical agents with no real room for ‘choice’ – we know what their behaviour will be in advance, and it is unchangeable.

There is also the problem of fungibility: is it fair to suggest that joining a gym gives someone the same kind of satisfaction as eating a donut? Or that eating a donut gives the same feeling as owning a car? These nuances are lost in the aggregated world of ‘utils,’ a unit which has no relation to anything else and hence is hard to verify – at its worst, utility is simply circular: only measurable by the same behaviour it supposedly explains.

Economists have a standard response to contentions that utility is unrealistic. They will assert that, even though utility doesn’t really ‘exist’ – a position few would endorse, surely – it still follows that if preferences follow economist’s axioms, then an effective utility function can be derived. That is: utility is not meant to be taken literary, but economist’s assumptions are sufficient to ensure a relationship between preferences that is functionally the same thing. So it would appear the only way out for opponents of utility is to critique the axioms. I don’t believe this is true, but the axioms are worth critiquing before I explain why.

The two most important axioms required to derive a basic utility function are completeness and transitivity. There are other axioms that are also commonly used – independence, non-satiation, convexity - which are all vulnerable to criticisms, but since they pertain to the the exact form of a utility function, rather than the concept as a whole, I will focus only on completeness and transitivity. Without these, there is no utility function, whichever way you paint it.

The first axiom – completeness – is the idea that all relevant decisions can be definitively compared to one another: that is, there is no room for ‘I don’t know.’ There are clear problems with this. Often, it is hard to choose between two options, particularly if one is a bundle of many goods (e.g. two shopping baskets). In fact, as a decision rule this is generally computationally impossible. So people may act based on chance or impulse; they may seek advice or ask someone else to make the decision for them. What’s more, often people find it difficult to evaluate choices even after they’ve made them. Sometimes there is no ‘correct’ choice!

The other axiom, transitivity, implies that people will be consistent in their ordering of preferences. If I prefer A to B, and B to C, I will prefer A to C. It is an important axiom because, even if preferences are complete, a violation of transitivity means that utility functions can basically have any shape and therefore be pretty useless for clear calculations. While I expect numerous behavioural quirks suggest transitivity may be violated under certain circumstances, overall it is a fair axiom – for the individual. However, it has been known for some time that, once we have more than two agents, it becomes impossible to establish a clear, consistent ordering of preferences for the group. This isn’t moving the goalposts: it is highly relevant when we are using representative agents for the entire economy. (This problem also applies to the aforementioned independence axiom).

My most important point, though, is that even if preferences do follow all the axioms, utility is still highly flawed. This is because, like so many neoclassical models, all utility functions give us is a static snapshot of the economy (or individual) at a particular point in time, and there is no room for change. The simple fact that preferences are highly volatile and will be different in the morning and the evening, or in summer and winter, is enough to render utility useless for practical questions about the economy, which must surely incorporate time. Similarly, preference reversal has shown that the way options are presented has a large impact on the choice made by somebody, suggesting again that underlying ‘preferences’ are highly subject to change, and not really useful for the practical purpose of predicting behaviour. One can only wonder how utility might deal with a theory such as multiple selves, which would surely create the aforementioned aggregation problems for preferences, but for one person!

Now, I can almost hear the cries of “ah, but what is your alternative?” Actually, that doesn’t matter for the immediate critique. If I have a map of London Underground and I’m in New York, I’m not going to use it (even less so if I have a map of a fantasy land that exists only in the minds of economists). To push the analogy a little further, it is worth asking what I would do in this situation. I can think of two possibilities: either ask for help, or follow some simple rules of thumb based on what knowledge I have. This is the strategy economists should adopt.

In the case of ‘asking for help,’ what I mean is that economists should turn to other social sciences; namely, psychology, which has a far more empirically driven methodology than economics and has numerous explanations of behaviour. Economists truly interested in understanding human behaviour – rather than preserving their favoured assumptions – should collaborate with psychologists to create sound behavioural foundations.

Until then, economists should be content with simple empirically observed rules of thumb and intuitive aggregate relationships (they already do this with the marginal propensity to consume). Objections of ‘but Lucas Critique‘ are special pleading, since preferences are also liable to change with political decisions. In fact, I’d shout ‘Lucas Critique’ right back at economists, and suggest that they spend less time on the impossible task of making their models ‘immune’ to the Lucas Critique, while spending more evaluating the ever-changing relationship between policy and observation. It is better for economists to be vaguely right than precisely wrong.

Out of all the concepts in neoclassical economics, none is more imaginary, absurd and empirically falsified than utility. Economists supposedly follow a methodology of strict positivism, and based on the experimental evidence against utility, there is surely no reason to keep it. Yet for some reason, it doesn’t seem to attract the same level of criticism as other areas of neoclassical economics. Personally, I am puzzled as to why.

Producer Sovereignty and the Irrelevance of Markets

Neoclassical (and Austrian) economics as a whole tend to emphasise market forces as the dominant determinant of employment, distribution and output in the economy. In the neoclassical theory of the firm, firms are something of a ‘black box,’ inside which uniform inputs are uniformly processed into uniform outputs. The firm can be thought of as an agent – or collection of agents – maximising some goal subject to resource constraints.  The most commonly used version of this is the perfectly competitive firm, which treats prices as a given, has the single aim of maximising profits and makes ‘normal’ profits. However, even more elaborate theories of the firm – such as ones where managers have objectives that conflict with those of shareholders – retain the standard assumption that the exhibited behaviour of the firm can be deduced from the behaviour of optimising agents inside it. Firms are rarely assumed to have internal differences in production techniques. Instead, they simply serve as channels, coordinated by supply and demand, through which resources are allocated.

But there is good reason to believe producers, rather than the impartial ‘laws’ of demand and supply, are the dominant force in an economy. It is a stretch to suggest that products are merely the expression of consumer preferences; after all, consumers rarely have input directly into the production process. Products are created by a firm and the consumers role is passive in that they can only choose whether or not to reject it. There also exists a power asymmetry between producers and consumers (and workers): since producers are the ones who own the products, they can ‘hold out’ for longer than those without. A capitalist alone can subsist; one who is merely a worker and/or consumer relies on the capitalist(s) for employment, goods and services.

In neoclassical theory, any deviations from perfect competition, and even the mere existence of firms, is thought to be either a source of inefficiencies, a result of them, or both. Hence, an ‘ideal,’ Pareto Efficient economy is thought to be one of perfectly competitive, tiny firms, which have no individual impact on the market in which they are situated. Any questions asked about firms proceed from the premise of which ‘frictions’ we can blame for the observed real world deviation from this ideal.

Several questions about how firms work and their role in the economy are never asked in neoclassical economics. First, what really goes on inside the firm: how are organisation and management used to impact the ability of the firm to convert inputs into outputs? Second, what is the nature of ‘market power?’ Could it be that some industries are so characterised by ‘market power’ that it no longer makes sense to talk about ‘the market’ as a meaningful concept? Third, to what extend do ‘imperfections’ such as these – organisation, market power, scale – actually create beneficial effects that we would not observe in the world of perfect competition?

I believe that, under contemporary capitalism, firms have such an impact that it makes more sense to use ‘the firm’ as an epistemological starting point than ‘the market.’ I also believe that, at least from material point of view, large firms are probably a superior system to one resembling the perfectly competitive ’ideal.’

The competitive ideal seems illogical when applied to the real world. Market forces can be inherently uncertain and costly to adjust to. Any firm which is wholly subservient to market forces, and hence has no control over its future, is simply a terrible firm, and a poor prospect for any potential investor, shareholder or worker. Even consumers prefer an established brand they can trust, at least in the absence of regulation. Hence, no firm would go to an investor, shareholder or bank and say “I have a product, let’s see whether the market likes it or not;” what is expected is a clear strategy.

It would, of course, be wrong to suggest that firms are not under threat from the development on new technologies and from the demands of consumers. Even well established companies go bankrupt from time to time. Nevertheless, many firms persist for a long time, either because their position is that strong or because they insure themselves against market forces. Research and development can ensure a firm always has something new to offer and can adapt, should demand for a product fall or a new release flop. Horizontal integration - selling different products, perhaps in entirely different markets – can broaden a firm’s consumer base (Google’s massive diversification over the last decade is an example of this). Brand proliferation – the same firm creating multiple brands – can serve a similar purpose (think of the different cereals produced by Kellogg).

The challenge for a firm is to establish a degree of control over its respective market; the degree to which  it manages this will be a determinant of its success; its ‘competitive advantage.’ Hence, many of a firm’s actions have the purpose of cementing that firm’s position in the marketplace, rather than simply responding passively to outside market forces. Numerous behaviours exhibited by firms support this idea:

• Some firms seek market share as opposed to profits: they want to make sure they have sufficient control over their industry.
• Prices don’t change constantly depending on the state of the economy; firms keep them the same for long periods of time to save money when performing calculations and to be able to produce projections.
• Branding, advertising, marketing and various offers are used to gain and retain customers so that the firm has at least a minimum flow of demand it can rely on. The mantra that it is far more costly to acquire new customers than retain old ones is well known; hence, firms try to make sure they are as unaffected by the whims of consumers as possible.
• Firms control supply through deals, perhaps exclusive, with suppliers; better yet, they can establish control of the supply chain themselves (vertical integration).

Firms also need to establish control over the labour market, as they often rely on the commitment of workers to a specific position in their organisation. The fact that knowledge and skills are often organisation-specific makes the cost of leaving – for both employer and employee – higher, and this effect becomes more amplified as one moves up the hierarchy of the organisation. The result is that the cost of even one worker leaving are often estimated to be well above their salary. It is no use starting a project if you know that, half way through, your manager – with his unique knowledge of what is going on – will just leave and work elsewhere. So firms retain workers with promises of career progression and rewards, as well as establishing a psychological commitment to their organisation. The most extreme example of this is the Japanese ‘employment for life‘ approach, which has proved to be remarkably competitive; moreso than many of its western counterparts.

The existence of long lived companies with significant influence over forces supposedly determined by ‘the market’ creates another problem for the state-market dichotomy. Many companies are economically bigger than countries or state and local governments, and hence their decisions have considerable political implications. A large company setting up shop in a small town, or even small country can significantly alter the landscape there.

Unfortunately, many supporter of “free markets” are driven to defending the actions of large, centralised entities as apolitical. This perspective is based on the false premise that they are simple conduits for scarcity and consumer preferences, rather than actively determining and influencing these things. It is clear this influence has largely driven us away from what economists typically mean when they speak of a ‘market.’ The implication is that, whatever you want to call the current system, it is vital that the entities which characterise it, with their significant impact on production, distribution and exchange, should be put into the political spotlight.

Against Friedman: Why Assumptions Matter

I have previously discussed Milton Friedman’s infamous 1953 essay, ‘The Methodology of Positive Economics.’ The basic argument of Friedman’s essay is the unrealism of a theory’s assumptions should not matter; what matters are the predictions made by the theory. A truly realistic economic theory would have to incorporate so many aspects of humanity that it would be impractical or computationally impossible to do so. Hence, we must make simplifications, and cross check the models against the evidence to see if we are close enough to the truth. The internal details of the models, as long as they are consistent, are of little importance.

The essay, or some variant of it, is a fallback for economists when questioned about the assumptions of their models. Even though most economists would not endorse a strong interpretation of Friedman’s essay, I often come across the defence ’it’s just an abstraction, all models are wrong’ if I question, say, perfect competition, utility, or equilibrium. I summarise the arguments against Friedman’s position below.

The first problem with Friedman’s stance is that it requires a rigorous, empirically driven methodology that is willing to abandon theories as soon as they are shown to be inaccurate enough. Is this really possible in economics? I recall that, during an engineering class, my lecturer introduced us to the ‘perfect gas.’ He said it was unrealistic  but showed us that it gave results accurate to 3 or 4 decimal places. Is anyone aware of econometrics papers which offer this degree of certainty and accuracy? In my opinion, the fundamental lack of accuracy inherent in social science shows that economists should be more concerned about what is actually going on inside their theories, since they are less liable to spot mistakes through pure prediction. Even if we are willing to tolerate a higher margin of error in economics, results are always contested and you can find papers claiming each issue either way.

The second problem with a ‘pure prediction’ approach to modelling is that, at any time, different theories or systems might exhibit the same behaviour, despite different underlying mechanics. That is: two different models might make the same predictions, and Friedman’s methodology has no way of dealing with this.

There are two obvious examples of this in economics. The first is the DSGE models used by central banks and economists during the ‘Great Moderation,’ which predicted the stable behaviour exhibited by the economy. However, Steve Keen’s Minsky Model also exhibits relative stability for a period, before being followed by a crash. Before the crash took place, there would have been no way of knowing which model was correct, except by looking at internal mechanics.

Another example is the Efficient Market Hypothesis. This predicts that it is hard to ‘beat the market’ – a prediction that, due to its obvious truth, partially explains the theory’s staying power. However, other theories also predict that the market will be hard to beat, either for different reasons or a combination of reasons, including some similar to those in the EMH. Again, we must do something that is anathema to Friedman: look at what is going on under the bonnet to understand which theory is correct.

The third problem is the one I initially honed in on: the vagueness of Friedman’s definition of ‘assumptions,’ and how this compares to those used in science. This found its best elucidation with the philosopher Alan Musgrave. Musgrave argued that assumptions have clear-if unspoken-definitions within science. There are negligibility assumptions, which eliminate a known variable(s) (a closed economy is a good example, because it eliminates imports/exports and capital flows). There are domain assumptions, for which the theory is only true as long as the assumption holds (oligopoly theory is only true for oligopolies).

There are then heuristic assumptions, which can be something of a ‘fudge;’ a counterfactual model of the system (firms equating MC to MR is a good example of this). However, these are often used for pedagogical purposes and dropped before too long. Insofar as they remain, they require rigorous empirical testing, which I have not seen for the MC=MR explanation of firms. Furthermore, heuristic assumptions are only used if internal mechanics cannot be identified or modeled. In the case of firms, we do know how most firms price, and it is easy to model.

The fourth problem is related to above: Friedman is misunderstanding the purpose of science. The task of science is not merely to create a ‘black box’ that gives rise to a set of predictions, but to explain phenomena: how they arise; what role each component of a system fills; how these components interact with each other. The system is always under ongoing investigation, because we always want to know what is going on under the bonnet. Whatever the efficacy of their predictions, theories are only as good as their assumptions, and relaxing an assumption is always a positive step.

Hence, the ‘it still behaves as if it matches our theories’ mentality of economists can easily be shown to be quite absurd, for example:

Consider the following theory’s superb record for prediction about when water will freeze or boil. The theory postulates that water behaves as if there were a water devil who gets angry at 32 degrees and 212 degrees Fahrenheit and alters the chemical state accordingly to ice or to steam. In a superficial sense, the water-devil theory is successful for the immediate problem at hand. But the molecular insight that water is comprised of two molecules of hydrogen and one molecule of oxygen not only led to predictive success, but also led to “better problems” (i.e., the growth of modern chemistry).

If economists want to offer lucid explanations of the economy, they are heading down the wrong path (in fact this is something employers have complained about with economics graduates: lost in theory, little to no practical knowledge).

The fifth problem is one that is specific to social sciences, one that I touched on recently: different institutional contexts can mean economies behave differently. Without an understanding of this context, and whether it matches up with the mechanics of our models, we cannot know if the model applies or not. Just because a model has proven useful in one situation or location, it doesn’t guarantee that it will useful elsewhere, as institutional differences might render it obsolete.

The final problem, less general but important, is that certain assumptions can preclude the study of certain areas. If I suggested a model of planetary collision that had one planet, you would rightly reject the model outright. Similarly, in a world with perfect information, the function of many services that rely on knowledge-data entry, lawyers and financial advisors, for example-is nullified. There is actually good reason to believe a frictionless world such as the one at the core of neoclassicism leaves the role of many firms and entrepreneurs obsolete. Hence, we must be careful about the possibility of certain assumptions invalidating the area we are studying.

In my opinion, Friedman’s essay is incoherent even on its own terms. He does not define the word ‘assumption,’ and nor does he define the word ‘prediction.’ The incoherence of the essay can be seen in Friedman’s own examples of marginalist theories of the firm. Friedman uses his new found, supposedly evidence-driven methodology as grounds for rejecting early evidence against these theories. He is able to do this because he has not defined ‘prediction,’ and so can use it in whatever way suits his preordained conclusions. But Friedman does not even offer any testable predictions for marginalist theories of the firm. In fact, he doesn’t offer any testable predictions at all.

Friedman’s essay has economists occupying a strange methodological purgatory, where they seem unreceptive to both internal critiques of their theories, and their testable predictions. This follows directly from Friedman’s ambiguous position. My position, on the other hand, is that the use and abuse of assumptions is always something of a judgment call. Part of learning how to develop, inform and reject theories is having an eye for when your model, or another’s, has done the scientific equivalent of jumping the shark. Obviously, I believe this is the case with large areas of economics, but discussing that is beyond the scope of this post. Ultimately, economists have to change their stance on assumptions if heterodox schools have any chance of persuading them.

Economists Versus Physics

I’m not sure what it is about economics that makes both its adherents and its detractors feel the need to make constant analogies to other sciences, particularly physics, to try to justify their preferred approach. Unfortunately, this isn’t just a blogosphere phenomenon; the type of throwaway suggestion you get in internet debates. This problem appears in every area of the field, from blogs to articles to widely read economics textbooks.

Not too infrequently I will see a comment on heterodox work along the lines of “Newton’s theories were debunked by Einstein but they are still taught!!!!” Being untrained in physics (past high school) myself, I am grateful to have commenters who know their stuff, and can sweep aside such silly statements. As far as this particular argument – which is actually quite common – goes, the fact is that when studying everyday objects, the difference between Newton’s laws, quantum mechanics and general relativity is so demonstrably, empirically tiny that they effectively give the same results.

Even though quantum mechanics teaches us that in order to measure the position of a particle you must change its momentum, and that in order to measure its momentum you must change its position, the size of these ‘changes’ on every day objects is practically immeasurable. Similarly, even though relativity teaches us that the relative speed of objects is ‘constrained’ by the universal constant, the effect on everyday velocities is too small to matter. Economists are simply unable to claim anything close to this level of precision or empirical corroboration, and perhaps they never will be, due the fact that they cannot engage in controlled experiments.

Another, more worrying example, is Greg Mankiw’s widely read Macroeconomics textbook (7th ed, p. 395), when discussing estimates of the NAIRU:

If you ask an astronomer how far a particular star is from our sun, he’ll give you a number, but it won’t be accurate. Man’s ability to measure astronomical distances is still limited. An astronomer might well take better measurements and conclude that a star is really twice or half as far away as he previously thought.

Mankiw’s suggestion astronomers have this little clue what they are doing is misleading. We are talking about people who can calculate the existence of a planet close to a distant star, based on the (relatively) tiny ‘wobble’ of said star. Astronomers have many different methods for calculating stellar distances: parallax, red shift, luminosity; and these methods can be used and cross-checked against one another. As you will see from the parallax link, there are also in-built, estimable errors in their calculations, which can help them straying too far off the mark.

While it is true that at large distances, luminosity can be hard to interpret (a star may be close and dim, or bright and far away) Mankiw is mostly wrong. Astronomers still make many, largely accurate predictions, while economist’s predictions are at best contested and uncertain, or worse, incorrect. The very worst models are unfalsifiable, such as the NAIRU Mankiw is defending, which seems to move around so much that it is meaningless.

Another example is a classic case of economists misunderstanding the use of assumptions. This is from Jehle and Reny’s textbook, Advanced Microeconomics (3rd ed, preface XVI):

In the physical world, there is ‘no such thing’ as a frictionless plane or a perfect vacuum.

Perhaps not, but all these assumptions do is eliminate a known mathematical variable. This is not the same as positing an imaginary substance (utility) just so that mathematics can be used; or assuming that decision makers obey axioms which have been shown to be false time and time again; or basing everything on the impossible fantasy of perfect competition, which the authors go on to do all at once. These assumptions cannot be said to eliminate a variable or collection of variables; neither can it be said that, despite their unrealism, they display a remarkable consistency with the available evidence.

Even if we accept the premise that these assumptions are merely ‘simplifying,’ the fact remains that engineers or physicists would not be sent into the real world without friction in their models, because such models would be useless - in fact, in my own experience, friction is introduced in the first semester. Jehle and Reny do go on to suggest that one should always adopt a critical eye toward their theories, but this is simply not enough for a textbook that calls itself ‘advanced.’ At this level  such blatant unrealism should be a thing of the past, or just never have been used at all.

Economics is a young science, so it is natural that, in search of sure footing, people draw from the well respected, well grounded discipline of physics. However, not only do such analogies typically demonstrate a largely superficial understanding of physics, but since the subjects are different, analogies are often stretched so far that they fail. Analogies to other sciences can be useful to check one’s logic, or as illuminating parables. However, misguided appeals to and applications of other models are not sufficient to justify economist’s own approach, which, like other sciences (!), should stand or fall on its own merits.

Institutions and Economics

Recently, I’ve been reading a lot from the school of institutional economics. Consequently, I have noticed another problem with the way economists approach theory and evidence: the lack of institutional considerations. This can blind economists to the fact that they may be studying entirely different phenomenon due to differences between countries, periods of history, companies, genders, cultures and much more.

The standard procedure of economists is to derive a model rigorously, based on a set of assumptions or axioms. Economists, unlike physicists, cannot perform controlled experiments in order to verify these models. Instead, empirical corroboration entails the use of econometrics to verify predictions. Economists must rely on collections of data, sometimes from disparate sources, and try to ‘correct’ these collections of data for said disparities. Economists then perform regressions in an attempt to isolate the relationship between two variables, and cautiously interpret the results. As explained more fully in the paragraphs below, the problem with this approach is that institutional differences could mean that some of the data collections are simply irrelevant, whether or not they disagree with the predictions of the theory in question. 

Problems with this Methodology

It appears that underlying this methodology used by economists to evaluate and analyze collections of data is a search for unifying principles that can be applied to all economies across space and time. The economic models of both neoclassical and heterodox schools reflect evidence a discipline aiming to isolate the true mechanics of the economy and build a model around it. The mentality often seems to be that, if only we could isolate the true mechanics of the economy, we’d be able to understand the economy and make informed policy decisions based on our ideal framework.

I expect many economists would probably agree that the institutional, legal, and cultural contexts are not the same for all economies. However, many economic models and the economist’s rhetoric reflect a discipline looking to uncover an equivalent of physical laws. Indeed, Larry Summers went so far as to claim that “the laws of economics are like the laws of engineering. One set of laws works everywhere.”

Even though most rational minds would disagree with Larry Summers, I find there is a tendency among economists to imagine that the institutional, legal, and cultural contexts are viewed as ‘constraints’ against which the ‘underlying mechanics’ of the economy are continually pushing. However, there is good reason to believe that the ‘real’ mechanics of the economy are determined by the context in which the economy operates, rather than said context merely influencing the economy exogenously. Here are some historic and contemporary examples to illustrate my point.

Industrialisation: the US versus England

English firms were fairly small during the industrial revolution. For reasons beyond the scope of this blog post, firms typically took it upon themselves to educate and train new employees on the job. Such a system diminishes the need for state education, at least from a labour market standpoint, and it wasn’t until the late 19th century that public education was finally established, by which time England was industrialised and the old system was becoming obsolete. In contrast, the USA followed a different path. During the growth period of the US, firms generally emphasised large production lines, and had a more ‘flexible’ approach to employment. Such an approach required that firms could rely on the competence of the average worker, and over the course of the US industrial revolution state education increased substantially, reaching something approximating a fully public system at around the same time as England, even though England was much later in its development phase. Both strategies successfully industrialised their countries; both presented different needs from a policy perspective. But using a single model to inform policy in these two countries would clearly be a mistake.

A similar contrast can be seen with Denmark and Japan. Historically, Japan has had a policy of lifelong employment, which means a majority of workers are, well, employed for life (the model may be waning due to the effects of the lost decade, but it was robust during Japan’s impressive industrialisation period). What would be the effect of restrictions on hiring and firing with such a model? It’s highly unlikely there would be much effect; in fact, the model itself is partly based on such regulations. But what if similar restrictions were applied to Denmark’s dynamic ‘flexicurity‘ model, in which hiring and firing is incredibly easy but there are strong social safety nets? I expect it would cause a lot of problems for employers and employees alike, as Danish firm’s strategies are built around being able to gain and shed workers quickly. On top of that, the safety net makes workers more willing to accept such treatment, as well as having obvious humanitarian attractions.

Again, though these two models are different – almost diametrically opposed, in fact – both have coped with recessions relatively well (in terms of unemployment). The countries simply have different institutions that operate under different mechanics, and no model could capture both (feel free to read that as a challenge). Despite this, Japan has recently enacted some ‘neoliberal’ reforms, perhaps based on the mistaken belief that they need to ‘free up’ the ‘underlying’ mechanics of the economy. Time will tell whether or not this was a smart move.

The Scandinavian Ideal

Apart from labour markets, there is another good example of interdependent institutions, laws and culture: the oft-cited Sweden. Both free marketeers and leftists like to hold Sweden up as an example of their ideas in action. “Look at the vast redistribution, unions and public goods!” Is the cry of the leftists. Meanwhile, the rightists will assert that beneath such institutions lies a relatively light touch, ‘neoliberal’ regulatory structure. In any many ways both are right; but in many more ways they are both wrong. Both approaches take the economy of Sweden and suggest that due to X, Y or Z policy, it is the way to go. But neither appreciate how the institutions identified by both fit together.

Sweden is historically a high-trust society and as such regulation is relatively simple. Even contract law is far less complex than that you will find in the UK or the States. Many businesses do something akin to ‘self regulation,’ reporting their own data to government agencies. Similarly, while it is questionable whether the generous welfare state is a cause of the trust, it is not unreasonable to suggest that the two are complementary. Furthermore, as in the case of Denmark, generous safety nets go well with light regulation in terms of dynamism. The approach has serious attractions, but only if the two institutions are combined: furthermore, it may well be the case that trust is a necessary condition for both of these institutions in the first place. Once more it is clear that certain historical circumstances have given rise to a specific set of ‘optimal’ policies that could not be applied elsewhere.

So if we take data points from between such disparate countries, is it really meaningful to try and ‘adjust’ them for this type of difference? What we are studying are economies with very different underlying mechanics. To aggregate over them and take the average result is to reduce the data to meaninglessness. What is needed is a historical, institutional perspective that understands how different aspects of the economy fit together, and how the economy fits into the background of politics, history, culture (not to mention to environment – for example, on an island country, even a corner shop can be a monopoly).

What is best for an economy will depend on initial conditions and current institutions. These institutions are not ‘artificial’ impositions on the underlying economy; they are inevitable political decisions which have been born out of specific historical context, and hopefully fit the culture of the nation in question. It would be at best costly and destructive, and at worst basically impossible, to uproot these institutions in search of some ideal. As such, any discussion of economic policy must proceed based on acknowledgment of the mechanics created by different institutions.

Much of what I’m saying isn’t new at all. In fairness, most empirical economic papers are careful about announcing they have found surefire causal links. And there might be new techniques in econometrics that attempt to deal with the problems in the methodology I outlined above. Furthermore, I am not suggesting economists are not at all concerned with institutions or history: development economists and Industrial Organisation economists speak of them frequently. Nevertheless, I believe the institutional considerations I described above create a clear methodological problem for large amount of economic theory, particularly macro.

This is because institutional considerations are a good reason that social scientists should be even more concerned about assumptions and real world mechanics than the physical sciences, and therefore that economists should be highly concerned with the historical, institutional and legal context of the economies they are studying. Such considerations are another nail in the coffin of Milton Friedman’s methodology, which posits that abstract models based on “unrealistic” assumptions are the appropriate approach to economic theory. Such an approach cannot even begin to comprehend institutional differences, and as such, applying any one theory – or group of theories – to every economy is bound to cause problems.